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A Business Cycle Analysis

1

Simon Gilchrist

Boston University and NBER

270 Bay State Road

Boston, MA 02215

sgilchri@bu.edu

and

John C. Williams

Board of Governors of the Federal Reserve System

Mail Stop 67

Washington, DC 20551

jwilliams@frb.gov

June, 1998

Abstract

This paper develops a dynamic stochastic general equilibrium model with

putty-clay technology that incorporates embodied technology, investment irre-

versibility, and variable capacity utilization. Low short-run capital-labor sub-

stitutability native to the putty-clay framework induces the putty-clay eﬀect of

a tight link between changes in capacity and movements in employment and

output. As a result, persistent shocks to technology or factor prices generate

business cycle dynamics absent in standard neoclassical models, including a

prolonged hump-shaped response of hours, persistence in output growth, and

positive comovement in the forecastable components of output and hours. Ca-

pacity constraints result in a nonlinear aggregate production function that im-

plies asymmetric responses to large shocks with recessions steeper and deeper

than expansions. Minimum distance estimation of a two-sector model that nests

putty-clay and neoclassical production technologies supports a signiﬁcant role

for putty-clay capital in explaining business-cycle and medium-run dynamics.

Keywords: putty-clay, vintage capital, business cycle, irreversibility, capacity

utilization.

JEL Classiﬁcation: D24, E22, E32

1

We are indebted to Steven Sumner for exemplary research assistance. We wish to thank Flint

Brayton, Jeﬀ Cambell, Thomas Cooley, Russel Cooper, Sam Kortum, John Leahy, Scott Schuh,

Dan Sichel, and participants at presentations at the NBER Impulse and Propagation Workshop and

Economic Fluctuations Meeting, Columbia University, Harvard University, NYU, the University of

Maryland, the Federal Reserve Bank of New York, and the Board of Governors of the Federal

Reserve for helpful comments. The opinions expressed here are not necessarily shared by the Board

of Governors of the Federal Reserve System or its staﬀ

1 Introduction

In this paper we develop a dynamic stochastic general equilibrium model based on

the putty-clay technology introduced by Johansen (1959). The putty-clay model

possesses a number of attractive features typically absent from models based on

neoclassical production functions, including a nonlinear short-run aggregate produc-

tion function, irreversible investment, variable capacity utilization, and endogenous

machine replacement. We investigate the implications of putty-clay technology for

macroeconomic dynamics at business cycle and medium-run frequencies.

2

A key

ﬁnding in the paper is that low short-run capital-labor substitutability native to the

putty-clay framework induces the putty-clay eﬀect of a tight link between changes in

capacity and movements in employment and output. In the short-run, an expansion

of employment quickly confronts sharp increases in marginal costs, owing to capac-

ity constraints. Once new capacity is in place, a sustained boom in employment

and output ensues, as ﬁrms fully employ new machines without reducing utilization

rates on existing capacity.

The putty-clay technology described above has two major implications for

business-cycle dynamics. First, persistent shocks to technology or factor prices

generate a prolonged hump-shaped response of hours, persistence in output growth,

and positive comovement between the forecastable components of output and hours.

These features of the business cycle, documented by Cogley and Nason (1995) and

Rotemberg and Woodford (1996), are absent in standard neoclassical models where

the response of hours peaks upon the impact of the shock and the dynamic re-

sponse of output closely follows that of the shock.

3

Second, large shocks generate

asymmetric responses of output and hours, with recessions steeper and deeper than

expansions. This asymmetric response is consistent with the empirical evidence

documented by Neftci (1984) and others, and reﬂects the fact that the short-run

elasticity of output with respect to labor is decreasing in the quantity of labor em-

ployed.

The empirical relevance of putty-clay technology is conﬁrmed by minimum dis-

tance estimation of a two-sector model that formally nests both the putty-clay and

neoclassical model within a common econometric framework. We ﬁnd that the dis-

2

In a recent paper, Caballero and Hammour (1998) study medium-run issues using a putty-clay

model. See also Malinvaud (1980) and Blanchard (1997).

3

Classic examples of neoclassical models are found in the real business cycle literature of Kydland

and Prescott (1982) and Hansen (1985).

1

tance between model and data moments is minimized for an estimated putty-clay

share of total output that is on the order of 50-75%. The data overwhelmingly reject

the restriction of no role for putty-clay capital.

The putty-clay model provides an intrinsically appealing description of capital

accumulation. In this framework, capital goods embody the level of technology and

the choice of capital intensity made at the time of their creation. Ex ante, the

choice of capital intensity—the amount of capital to be used in conjunction with

one unit of labor—is based on a standard neoclassical production function. Ex post,

the production function is of the Leontief form with a zero-one utilization decision

based on the output per hour of a given piece of capital relative to the prevailing

wage rate. Over time, as the economy grows and real wages rise, older vintages

of capital become too costly to operate given their current labor requirements and

they are mothballed or scrapped.

4

Putty-clay models have a long history in both the growth (Johansen (1959),

Solow (1962), Phelps (1963), Cass and Stiglitz (1969), Sheshinski (1967) and Calvo

(1976)) and investment literatures (Bischoﬀ (1971), Ando, Modigliani, Rasche and

Turnovsky (1974)). Due in part to computational complexities, these past litera-

tures mainly limited themselves to characterizing the long-run features of a putty-

clay economy or to partial equilibrium analysis of the investment sector. More

recently, interest in real business cycle models has spurred a revival in alternative

speciﬁcations of technology, including putty-clay.

5

Atkeson and Kehoe (1994) de-

velop a model where the energy-intensity of production is the putty-clay factor.

Their model possesses the property of a cutoﬀ rule for utilizing capital—based on

the price of energy as opposed to the wage—but their dynamic analysis focuses on

the case where capital is always fully utilized. Cooley, Hansen and Prescott (1995)

study a model where each period physical capital is assigned to plots of land, the

supply of which is assumed to be ﬁxed for the dynamic analysis. Although this

model features variable capacity utilization, the assumption that the land intensity

of capital can be freely changed after one period eﬀectively cuts the dynamic link

4

The eﬀects of technological lock-in motivate the machine replacement problem ﬁrst addressed

by Johansen (1959) and Calvo (1976), and more recently formalized in a dynamic programming

environment by Cooper and Haltiwanger (1993) and Cooley, Greenwood and Yorukoglu (1994).

5

Vintage models have also experienced a resurgence of late as witnessed by Benhabib and Rus-

tichini (1991), Benhabib and Rustichini (1993), Caballero and Hammour (1996), Campbell (1994),

Cooper, Haltiwanger and Power (1995), Boucekkine, Germain and Licandro (1997), and Green-

wood, Hercowitz and Krusell (1997).

2

between capital and labor that is key to the putty-clay eﬀect.

Our model incorporates what we view as the essential features of the putty-

clay framework, including variable capacity utilization and investment irreversibil-

ity. Although the assumption of ex post Leontief technology may at ﬁrst seem

unrealistically stark, the resulting aggregate production function embeds, depend-

ing on the model’s parameterization, both the relatively ﬂat short-run supply curve

usually associated with a neoclassical model and a reverse L-shaped supply curve

traditionally associated with the putty-clay framework. In addition, the model’s

micro-foundations are largely consistent with microeconomic evidence on the impor-

tance of plant shutdowns as a short-run adjustment margin (Bresnahan and Ramey

(1994)) and the lumpiness of investment at the plant level (Doms and Dunne (1993),

Cooper et al. (1995), Caballero, Engel and Haltiwanger (1995)).

The distinguishing features of the model developed in this paper are nicely illus-

trated by the experiment of a reduction in the cost of producing new capital goods.

This reduction in capital cost raises the return to new capital and causes a surge

in investment, which over time leads to rising aggregate output and consumption.

Initially, however, ﬁrms’ eﬀorts to raise employment encounter capacity constraints

owing to the putty-clay nature of capital. As a result of this low short-run sub-

stitutibility of labor for capital, the initial aggregate response of both output and

hours is muted. To eﬃciently increase production, ﬁrms invest in new capacity,

that, once in place, can be utilized by an expanded workforce. Ex post ﬁxity of the

capital-labor ratio for existing capacity implies that labor can only be reallocated

to new machines at the cost of mothballing existing capacity. Therefore, there is

an incentive to simultaneously utilize both new and exisiting capital. This dynamic

linkage between capital and labor causes hours and output to rise together for a

sustained period of time following the initial burst of investment, generating the

putty-clay eﬀect.

The dynamic response to a large increase in the cost of new capital goods diﬀers

in some respects from that described above. In this case, a large fraction of the over-

all adjustment of output and hours is accomplished through an immediate reduction

in capacity utilization. Thus, the putty-clay model naturally delivers asymmetric

responses to positive and negative shocks, with the asymmetries increasing in the

magnitude of the shock.

3

2 The Model

In this section we describe the model and derive the equilibrium conditions. Each

capital good possesses two deﬁning qualities: its level of embodied technology and

its capital intensity. The underlying or ex ante production technology is assumed

to be Cobb-Douglas with constant returns to scale, but for capital goods in place,

production possibilities take the Leontief form: there is no ex post substitutabil-

ity of capital and labor. In addition to aggregate technological change, we allow

for the existence of idiosyncratic uncertainty regarding the productivity of invest-

ment projects. As in Campbell (1994), the introduction of heterogeneity within

vintages smooths the aggregate allocation and simpliﬁes computation of the equi-

librium. More importantly, such idiosyncratic uncertainty implies the existence of

a well-deﬁned aggregate production function despite the Leontief nature of the mi-

croeconomic utilization choice.

Once in place, capital goods are irreversible, that is, they cannot be converted

into consumption goods or capital goods with diﬀerent embodied characteristics,

and have zero scrap value. Firms can choose, however, whether or not to operate

a given unit of capital depending on the proﬁtability of doing so in the current

economic environment. We assume that there are no costs of taking machines or

workers on- and oﬀ-line. As such, the utilization choice is purely atemporal. The

optimal utilization choice for each unit of capital is determined by the diﬀerence

between the (labor) productivity of the capital and the cost of utilizing the capital,

which in the absence of other costs equals the wage rate. If the productivity of a

unit of capital exceeds the wage rate, the capital is used in production, otherwise,

it is not. In equilibrium, the wage rate, capacity utilization rate, and levels of em-

ployment, production, consumption, and investment are determined jointly by the

dynamic optimizing behavior of households and ﬁrms. To characterize the equilib-

rium allocation, we ﬁrst discuss the optimization problem at the project level and

then describe aggregation from the project level to the aggregate allocation.

2.1 The Investment Decision

Each period a set of new investment “projects” becomes available. Constant returns

to scale implies an indeterminacy of scale at the level of projects, so without loss of

generality, we normalize all projects to employ one unit of labor at full capacity. We

4

refer to these projects as “machines.” Capital goods require one period for initial

installation and then are productive for M ≥ 1 periods. The productive eﬃciency

of machine i initiated at time t is aﬀected by two stochastic productivity terms,

one idiosyncratic, one aggregate. In addition, we assume all machines, regardless of

their relative eﬃciency, fail at an exogenously given rate that varies by the age of

the machine. In summary, capital goods are heterogeneous and are characterized by

three attributes: vintage (age and level of aggregate embodied technology), capital-

intensity, and the realized value of the idiosyncratic productivity term.

The productivity of each machine, initiated at time t, diﬀers according to the

log-normally distributed random variable, θ

i,t

, where

log θ

i,t

∼ N(log θ

t

−

1

2

σ

2

, σ

2

).

The aggregate index θ

t

measures the mean level of embodied technology of vintage t

capital goods and σ

2

is the variance of the idiosyncratic shock. The mean correction

term −

1

2

σ

2

implies E(θ

i,t

|θ

t

) = θ

t

. We assume θ

t

follows a stochastic process with

mean gross growth rate (1+g)

1−α

. For the sake of notational clarity, in the following

discussion we abstract from disembodied aggregate technological change of the type

typical in the real business cycle literature. The inclusion of a stochastic disembodied

technology process is straightforward and used in section 3 when analyzing model

dynamics.

Before investment decisions are made, the economy-wide level of vintage tech-

nology θ

t

is observed but the idiosyncratic shock to individual machines is not. We

also assume that after the revelation of the idiosyncratic shock, further investments

in existing machines are not possible. Subject to the constraint that labor employed,

L

i,t+j

, is nonnegative and less than or equal to unity (capacity), ﬁnal goods output

produced in period t +j by machine i of vintage t is

Y

i,t+j

= θ

i,t

k

α

i,t

L

i,t+j

,

where k

i,t

is the capital-labor ratio chosen at the time of installation. Denote the

labor productivity of a machine by

X

i,t

≡ θ

i,t

k

α

i,t

.

The only variable cost to operating a machine is the wage rate, W

t

. Idle ma-

chines incur no variable costs and have the same capital costs as operating machines.

6

6

The model can be extended to allow for a ﬁxed labor cost per unit of capital. Under such a

5

Figure 1: Steady-state Distribution of Labor Productivity

0

1

2

3

4

0 1 2 3 4 5 6

0

1

2

3

4

0 1 2 3 4 5 6

0.0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6

Aggregate (left axis)

Newest Vintage(right axis)

Project level Productivity (x)

D

i

s

t

r

i

b

u

t

i

o

n

w

e

i

g

h

t

e

d

b

y

i

n

v

e

s

t

m

e

n

t

Equilibrium

Wage

Given the Leontief structure of production, these assumptions imply a cutoﬀ value

for the minimum eﬃciency level of machines used in production: those with pro-

ductivity X

i,t

≥ W

t

are run at capacity, while those less productive are left idle.

To illustrate these ideas, Figure 1 shows the steady-state distribution of labor

productivity for the model calibrated to parameters speciﬁed below. The height of

the distribution reﬂects the number of machines at any given productivity level. The

cutoﬀ value for the wage is shown as a vertical line. Capital goods with productivity

lying to the right of the cutoﬀ are used in production, those to the left are idle.

Capital utilization is given by the area in the shaded region divided by the total

area under the distribution.

Figure 1 also shows the distribution of labor productivity for the most recent

vintage (right scale). Its position on the horizonal axis reﬂects both the current level

of technology and the capital intensity of new machines. Owing to trend growth

speciﬁcation, it is optimal to permanently scrap machines whose eﬃciency falls below some cutoﬀ.

This modiﬁcation substantially complicates the investment decision and is left for future research.

6

and relatively long-lived capital, the average labor productivity of the most recent

vintage is substantially higher than the average labor productivity of existing ma-

chines. Obsolescence through embodied technical change implies that old vintages

have lower average utilization rates than new vintages. Note that trend growth in

investment—due to population growth and technological change—causes the aggre-

gate distribution to be skewed.

To derive the equilibrium allocation of labor, capital intensity, and investment,

we begin by analyzing the investment and utilization decision for a single machine.

Deﬁne the time t discount rate for time t +j income by

˜

R

t,t+j

≡

¸

j

s=1

R

−1

t+s

, where

R

t+s

is the one period gross interest rate at time t + s. At the machine level,

capital intensity is chosen to maximize the present discounted value of proﬁts to the

machine:

max

k

i,t

,{L

i,t+j

}

M

j=1

E

t

−k

i,t

+

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)(X

i,t

−W

t+j

)L

i,t+j

¸

, (1)

s.t. 0 ≤ L

i,t+j

≤ 1, j = 1, . . . , M,

0 < k

i,t

< ∞,

where δ

j

is the probability a machine has exogenously failed by j periods and ex-

pectations are taken over labor productivity, whose realization depends on the time

t idiosyncratic shock, and future values of wages and interest rates.

Because investment projects are identical ex ante, the optimal choice of the

capital-labor ratio is equal across all machines in a vintage; that is, k

i,t

= k

t

, ∀i.

Denote the average productivity of the entire stock of vintage t capital by X

t

=

θ

t

k

α

t

. Capital utilization for vintage s at time t is the ratio of labor employed to

employment capacity of the vintage, given by Pr(X

i,s

> W

t

|W

t

, θ

t

). Given the

log-normal distribution for θ

i,t

we obtain:

Pr(X

i,s

> W

t

|W

t

, θ

t

) = 1 −Φ(z

s

t

),

where Φ(·) is the c.d.f. of the standard normal and

z

s

t

≡

1

σ

log W

t

−log X

s

+

1

2

σ

2

,

Similarly, capacity utilization for vintage s at time t is the ratio of actual output

produced from the capital of a given vintage to the level of output that could be

7

produced at full capital utilization. Letting F(·) denote the cdf of X

i,t

, capacity

utilization is formally deﬁned as

∞

X

is

>Wt

X

i,s

dF(X

i,s

)

∞

0

X

i,s

dF(X

i,s

)

= (1 −Φ(z

s

t

−σ))

where the equality follows from the log-normality of X

i,t

.

7

If all machines were fully utilized, labor productivity would simply equal X

t

.

With partial utilization, labor productivity also depends on capital and capacity

utilization. The average product of labor for vintage s capital at time t, is

APL

s

t

=

1 −Φ(z

s

t

−σ)

1 −Φ(z

s

t

)

X

s

.

Letting φ(·) denote the p.d.f. of the standard normal, the marginal product of labor

for vintage s capital at time t is

MPL

s

t

=

φ(z

s

t

−σ)

φ(z

s

t

)

X

s

.

For any given vintage, the marginal product of labor is equal to the eﬃciency of the

least productive machine of the vintage in operation.

8

Expected net income in period t from a vintage s machine, π

s

t

, conditional on

W

t

, is given by

π

s

t

= (1 −δ

t−s

)

1 −Φ(z

s

t

−σ)

X

s

−

1 −Φ(z

s

t

)

W

t

.

Substituting this expression for net income into equation 1 eliminates the future

choices of labor from the investment problem. The remaining choice variable is k

t

.

The ﬁrst order condition for an interior solution for k

t

is given by

9

k

t

= αE

t

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)

1 −Φ(z

t

t+j

−σ)

X

t

¸

. (2)

7

Capacity utilization may be expressed as [E(Xi,s|Xi,s > Wt)/E(Xi,t)] Pr(Xi,s > Wt). We

then use the formula for the expectation of a truncated log-normal: If log(µ) ∼ N(ζ, σ

2

), then

E(µ|µ > χ) =

(1−Φ(γ−σ))

(1−Φ(γ))

E(µ) where γ = (log(χ) −ζ)/σ (Johnson, Kotz and Balakrishnan 1994).

8

Normalizing the quantity of machines at unity, marginal product equals the increment to ma-

chine output obtained by reducing the eﬃciency cutoﬀ Wt, divided by the increment to labor input

obtained by reducing the cutoﬀ Wt. The increment to output equals

∂(1−Φ(z

s

t

−σ)Xs)

∂z

s

t

∂z

s

t

∂Wt

, while the

increment to labor equals

∂(1−Φ(z

s

t

))

∂z

s

t

∂z

s

t

∂Wt

.

9

This ﬁrst order condition is obtained by taking the derivative of the proﬁt function with respect

to kt, recognizing that in equilibrium, the marginal machine earns zero quasi-rents so that

∂π

s

t

∂z

s

t

≡

1

σ

φ(z

s

t

−σ)Xs −

1

σ

φ(z

s

t

)Wt = 0.

8

New machines are put into place until the value of a new machine (the present

discounted value of net income) is equal to the cost of a machine (k

t

)

k

t

= E

t

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)

1 −Φ(z

t

t+j

−σ)

X

t

(3)

−

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)

1 −Φ(z

t

t+j

)

W

t+j

¸

This is the free-entry or zero-proﬁt condition. The ﬁrst term on the right hand

side of equation 3 reﬂects the expected present discounted value of output adjusted

for the probability that the machine’s idiosyncratic productivity draw is too low to

proﬁtably operate the machine in period t + j. The second term likewise reﬂects

the expected present value of the wage bill, adjusted for the probability of such a

shutdown. This condition must hold as long as there is gross investment in period

t.

10

Equations 2 and 3 jointly imply that, in equilibrium, the expected present value

of the wage bill equals (1 −α) times the expected present value of revenues.

2.2 Aggregation

Aggregation of machine-level labor inputs and output is a two-step process. First,

labor input and output of machines in each vintage are aggregated into vintage

totals. Second, inputs and outputs from the M productive vintages are summed to

yield aggregate values. Total labor employment, L

t

, is

L

t

=

M

¸

j=1

1 −Φ(z

t−j

t

)

(1 −δ

j

)Q

t−j

. (4)

where Q

t−j

is the quantity of new machines started in period t−j, Φ(z

t−j

t

) is the idle

rate of those machines in period t, and δ

j

reﬂects the fact that a subset of machines

has failed completely. Aggregate ﬁnal output, Y

t

is

Y

t

=

M

¸

j=1

1 −Φ(z

t−j

t

−σ)

(1 −δ

j

)Q

t−j

X

t−j

. (5)

In the absence of government spending or other uses of output, aggregate consump-

tion, C

t

, satisﬁes

C

t

= Y

t

−k

t

Q

t

, (6)

where k

t

Q

t

is gross investment in new capital machines.

10

If the cost of a machine exceeds the value of a machine for all admissible values of kt no

investment is undertaken.

9

2.3 Preferences

To close the model, we specify the economic relationships that determine labor sup-

ply and savings decisions. We assume that the economy is made up of representative

households whose preferences are given by

1

1 −γ

E

t

∞

¸

s=0

β

s

C

t+s

(N

t+s

−L

t+s

)

ψ

N

t+s

1−γ

, (7)

where β ∈ (0, 1), γ > 0, ψ > 0, and N

t

= N

0

(1 +n)

t

is the household’s growing time

endowment.

11

Households optimize over these preferences subject to the standard

intertemporal budget constraint. We assume that claims on the proﬁt streams of

individual machines are traded; in equilibrium, households own a diversiﬁed portfolio

of all such claims.

The ﬁrst-order condition with respect to consumption is given by

U

c,t

=

β

1 +n

E

t

R

t,t+1

U

c,t+1

, (8)

where U

c,t+s

denotes the marginal utility of consumption. The ﬁrst-order condition

with respect to leisure and work is given by

U

c,t

W

t

+U

L,t

= 0, (9)

where U

L,t

denotes the marginal utility associated with an incremental increase in

work (decrease in leisure). This completes our description of the economy.

The rational expectations equilibrium is deﬁned to be the set of sequences of

prices and quantities such that each household and ﬁrm solves its respective maxi-

mization problem as described above, taking prices as given, and all markets clear.

The derivation of the deterministic steady state and its properties are found in

Gilchrist and Williams (1998b). In conducting the dynamic analysis we focus on de-

viations from the balanced growth path. The solution methodology for the dynamic

analysis is described in the appendix.

3 Model Dynamics

In this section we describe the model’s implications for business cycle and medium-

run dynamics in response to persistent shocks to factor prices; in the next section

11

We also considered the case of indivisible labor as in Hansen (1985) and Rogerson (1988). This

speciﬁcation alters the magnitude of the dynamic responses reported below but not the qualitative

properties of the model.

10

we turn our attention to permanent technology shocks. The purpose of this analysis

is not to argue for a speciﬁc theory of business cycles based on particular shocks,

but instead to document the putty-clay model’s dynamic properties and their corre-

spondence to those evident in the data for a wide variety of shocks. For the purpose

of comparison, we construct a neoclassical model of vintage capital, initially intro-

duced by Solow (1962). Details of this model are provided in the appendix. In the

vintage model, the restriction that ex post capital-labor ratios are ﬁxed is removed.

Thus, this model takes the standard Cobb-Douglas putty-putty formulation. The

two models are otherwise identical.

We focus primarily on three key business cycle properties: comovement, per-

sistence, and asymmetries. First, as emphasized by Lucas (1977), a fundamental

feature of the business cycle is that output movements across sectors exhibit positive

comovement. The real business cycle literature tends to focus on a particular inter-

pretation of comovement that is based almost exclusively on a model’s implications

for unconditional second moments of ﬁltered data; see, for example, Kydland and

Prescott (1991). Rotemberg and Woodford (1996) extend the notion of comovement

to the forecastable components of output, hours, and consumption. Using a VAR

model, they document that the forecastable components of these variables also ex-

hibit strongly positive comovement. Second, Cogley and Nason (1995) document

that output growth displays signiﬁcant positive serial correlation; that is, output

growth is persistent. Finally, there is a wide range of evidence that asymmetries

exist with respect to the business cycle and the dynamic response to particular

shocks. As documented below, the putty-clay model possesses a powerful internal

propagation mechanism that yields dramatic improvements over the neoclassical

model in all three dimensions.

3.1 The Short-Run Aggregate Supply Curve

Insight into the dynamic responses of the putty-clay model is provided by the short-

run aggregate supply curve (the inverse of the marginal product of labor). Here,

short-run refers to the time period during which the capital stock is ﬁxed. Figure 2

shows the short-run aggregate supply curve, computed as the markup 1/W, in log

deviations from the deterministic steady state, for the neoclassical vintage model

and three versions of the putty-clay model with diﬀerent degrees of idiosyncratic

uncertainty (measured by σ). For the neoclassical vintage model, the production

11

Figure 2: Short-run Aggregate Supply Curve

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

-0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

-0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

-0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

-0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05

Cobb-Douglas

σ = .25

σ = .15

σ = .05

Output (log deviation from steady state)

M

a

r

k

u

p

(

l

o

g

d

e

v

i

a

t

i

o

n

f

r

o

m

s

t

e

a

d

y

s

t

a

t

e

)

function is Cobb-Douglas implying that the SRAS is linear in logs. The SRAS of

the putty-clay model, however, is distinctly nonlinear. For very low values of σ, the

putty-clay SRAS curve becomes vertical for levels of output a few percent above

steady state. As σ increases, the SRAS curve of the putty-clay model becomes

less sharply curved and approaches that of the neoclassical vintage model as σ

approaches inﬁnity. Thus, the model developed in this paper embeds both the

reverse-L shaped aggregate supply curve traditionally associated with putty-clay

technology and the log-linear aggregate supply curve of the neoclassical production

function. The degree of idiosyncratic uncertainty determines the extent to which the

model’s short-run aggregate production function and dynamic responses are more

putty-clay or neoclassical in ﬂavor.

In the putty-clay model, the variable slope of the SRAS curve results from vary-

ing utilization rates of existing machines. Variable utilization is often suggested as

an explanation for the fact that empirical estimates of the short-run elasticity of pro-

duction with respect to labor inputs,

d lnY

d lnL

, are much closer to unity than to labor’s

12

share.

12

The intuition here is that a 1% increase in labor eﬀectively causes a 1%

increase in capital, through increased utilization, and hence a 1% increase in output.

This simple calculation relies on the assumption that capital goods are homogenous

however. It also ignores equilibrium determinants of utilization and capacity. In

the putty-clay model,

dY

dL

= w where w is the eﬃciency of the marginal machine.

As labor inputs increase, the quality of the marginal machine falls, guaranteeing

d ln(Y )

d ln(L)

< 1.

By considering optimal capacity choice, we can explicitly quantify

d ln(Y )

d ln(L)

. In

steady state, the short-run elasticity of output with respect to labor for the putty-

clay model equals 1 − α, the long-run labor share. If utilization rates rise above

steady-state, costs increase rapidly and

d lnY

d lnL

< 1 − α. The only way to justify

d lnY

d lnL

> 1 −α is to argue that ﬁrms frequently hold costly excess capacity. This is

sub-optimal from the ﬁrm’s point of view however. Hence, except in response to

large negative shocks, ﬁrms typically operate in a region where

d lnY

d lnL

1 − α, and

variable utilization does not provide measured short-run increasing returns to labor

in the putty-clay model.

Besides having important implications for utilization rates and their inﬂuence

on labor productivity, the variable slope of the putty-clay SRAS also implies that

dynamic responses to positive shocks diﬀers from those to negative shocks, as dis-

cussed below. Although not examined here, the nonlinear aggregate supply curve

also implies asymmetries in price adjustment in models with nominal rigidities.

3.2 Calibration

The models are calibrated using parameter values taken from Christiano and Eichen-

baum (1992) and Kydland and Prescott (1991), except for the trend growth rates,

which are averages over 1954–96.

13

We assume a period is one quarter of one year.

In annual basis terms, the calibrated parameters are β = 0.97, ρ = 1, ψ = 3, g =

0.018, n = 0.015, δ = 0.084, α = 0.36, M = ∞. The results reported in this

paper are not sensitive to reasonable variations in these parameters. When cali-

brating the model, the only parameter for which we do not have a prior estimate

is the variance of the idiosyncratic component of a machine’s productivity, σ

2

. As

12

Basu and Fernald (1997) provide a recent discussion.

13

These estimates are obtained from long-run restrictions, and, with one caveat, are therefore

valid for both the putty-clay model and the neoclassical model. The caveat is that variation in

σ has a small impact on steady-state properties through endogenous depreciation. Endogenous

depreciation alters the estimated δ by 1-2% and has only a very minor eﬀect on model properties.

13

discussed above, for large σ, the short-run aggregate supply curve is very close to

Cobb-Douglas. By lowering σ we increase the curvature of the short-run aggregate

supply curve and increase the degree to which the model displays dynamics unique

to the putty-clay structure. To make clear distinctions between the neoclassical and

putty-clay models we set σ = 0.15. Lowering σ to 0.1 does not alter model results

in any substantial manner; lowering σ much further causes numerical problems for

the dynamic solution methods. On the other hand, raising σ to 0.5 for almost all

essential purposes replicates the neoclassical model dynamics, while intermediate

values (σ = 0.2 − 0.25) provide results that are a combination of the neoclassical

and putty-clay model with low σ.

3.3 Capital Cost Shocks

We start by characterizing the eﬀect of a temporary but persistent shock to the

cost of producing capital goods relative to consumption goods. This is identical to

an increase in technology embodied in capital goods; henceforth, we describe it as

such.

14

We assume that embodied technology follows the process (1 −ρ

θ

L) ln θ

t

=

(1 −ρ

θ

L)t ln(1 +g) +u

t

, where u

t

is an i.i.d. innovation and L is the lag operator.

We set the autocorrelation coeﬃcient of the shock process at ρ

θ

= 0.95 implying a

half life for the shock of just under 14 quarters.

Figure 3 shows the impulse response function to output for both the putty-clay

model (upper panel) and the neoclassical model (lower panel) to a one percentage

point positive shock to embodied technology. The diﬀerence in output dynamics

between the two models is striking. For the putty-clay model, output rises very

little initially, steadily increases for a period of ﬁve years, and eventually returns to

steady state. For the neoclassical model, the peak response occurs at the onset of

the shock, after which output exhibits something close to exponential decay as it

returns to steady state. In the neoclassical model, output dynamics simply mirror

shock dynamics with no evidence of any interesting cyclical pattern. In the putty-

clay model, output exhibits a clear “hump-shaped” response that creates a slowly

unfolding and long-lasting business cycle.

Figure 3 also plots the impulse response of the Solow residual, conventionally

measured, for the putty-clay and neoclassical models. In both models, movements in

14

It is, not, however, the same as a distortionary shock to the cost of capital goods from a change

in taxes or that might result from a monetary disturbance in a model with nominal rigidities. Such

shocks aﬀect the equilibrium allocation but not the feasible allocation for the economy.

14

Figure 3: Persistent Cost of Capital Shock

0.0

0.2

0.4

0.6

0.8

0 5 10 15 20

Putty-Clay Model

Output

Solow Residual

Adjusted Solow Residual

years

0.0

0.2

0.4

0.6

0.8

1.0

1.2

0 5 10 15 20

Neoclassical Model

Output

Solow Residual

years

Figure 3: Persistent Cost of Capital Shock

the Solow residual are much smaller (by a factor of 3 to 5) than movements in output.

Hence, in both models, embodied technological change provides “magniﬁcation” as

usually measured by movements in output vis-a-vis the Solow residual. In addition

to magniﬁcation, the putty-clay model provides signiﬁcant positive comovement,

in levels and growth rates, between output and the Solow residual over the cycle.

This positive comovement stems from the fact that both output and the Solow

residual exhibit similar hump-shaped responses to embodied technological change.

In the neoclassical model, embodied shocks generate a negative correlation between

growth in output and the Solow residual over the ﬁrst ﬁve years.

The third line in the top panel of ﬁgure 3 shows the Solow residual, after cor-

recting for capital utilization. Initially, consistent with the arguments made above,

15

Figure 4: Persistent Cost of Capital Shock

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0 5 10 15 20

Investment

years

0.0

0.1

0.2

0.3

0.4

0.5

0 5 10 15 20

Labor

years

0

1

2

3

4

5

0 5 10 15 20

Q

years

-0.5

0.0

0.5

1.0

0 5 10 15 20

k

years

Putty-Clay Model

the correction has only a trivial eﬀect on the Solow residual. Over time, we see a

somewhat larger adjustment, but this adjustment reﬂects expanded capacity that

lowers the utilization rate of existing machines in later periods.

The upper panels of Figure 4 show the responses of investment and labor hours

in the putty-clay model to the same shock. Investment rises immediately as the

economy seeks to build new capital goods that embody the latest technology. Hours

increase and consumption falls in response to high real interest rates. The initial

expansion in hours is muted, however, owing to the sharply increasing short-run ag-

gregate supply curve embedded in the putty-clay model. As more capital is brought

16

on line, the short-run supply curve shifts out and labor expands further. As a result,

the peak labor response occurs three years after the onset of the shock.

The slow but sustained rise in hours above steady-state levels occurs because the

beneﬁts to building new capital goods are much greater if existing, eﬃcient capital

is not scrapped in the process. With ex post Leontief technology, labor cannot

be reallocated across machines to equate marginal products. To beneﬁt from new

machines without losing the productive services of existing capital, the economy

must hire new workers to operate these machines. Hence, as new machines become

operative, more labor is hired. Eventually, as the productive value of these machines

falls, labor returns to steady state. We refer to this dynamic linkage between labor

and machines as the putty-clay eﬀect.

Decomposing the investment dynamics into the quantity of new machines, Q,

and the capital intensity of each new machine, k, adds further insight into the

model’s dynamics. As shown in the lower panels of Figure 4, at the onset of the

shock, Q rises and k falls as a large number of low capital-intensity machines are

produced. This rapid expansion of inexpensive (in terms of foregone consumption)

machines shifts the short-run aggregate supply curve to the right and facilitates

the increase in labor input. This reliance on low eﬃciency capital does not persist,

however. As the real interest rate falls and the real wage rises, ﬁrms substitute into

high capital-intensity capital goods.

The capital-intensity of new machines remains at elevated levels for a number

of years as households store the beneﬁts of the temporary shock through increased

saving implying capital deepening. Rising capital intensities dramatically oﬀset

the exponential rate of decay in technology and consequently provide a sustained

increase in the eﬃciency levels of new machines for a number of years after the

shock has occurred.

15

Because machines are long-lived, this sustained increase in

eﬃciency levels of new machines translates into a sustained increase in total labor

productivity over a long horizon.

15

In the initial period, θt is 1% above steady state while k is 1.3% below steady state, implying

that x = θk

α

, the mean eﬃciency of new machines, is 0.75% percent above steady state. Six years

later θ is 0.3% above steady state while k is 1.1% above steady state, implying that x is still 0.7%

above steady state.

17

3.4 Labor Cost Shocks

We now consider the eﬀect of a temporary but highly persistent shock to the

marginal cost of labor. This shock may be interpreted as either a reduction in

the tax on wage income or a shock to preferences that reduces the marginal utility

of leisure relative to the marginal utility of consumption. Formally, we specify the

labor cost shock ln η

t

= ρ

η

ln η

t−1

+ e

t

, where e

t

is an i.i.d. innovation, and set

ρ

η

= 0.98. We embed η

t

in the labor-leisure ﬁrst-order condition given by equa-

tion 9. Figure 5 shows the responses of output, hours, and consumption to a one

percentage point reduction in the marginal cost of labor for the two models. The

hump-shaped response of output and hours in the putty-clay model observed in

response to the capital cost shock carries over to the labor cost shock.

The labor cost shock illustrates the ability of the two models to generate co-

movement between output, hours, and consumption. As seen in the ﬁgure, this

comovement is especially strong in the putty-clay model after the initial shock pe-

riod and is therefore present in the forecastable components. That is, starting from

the ﬁrst period, output, hours and consumption are rising for a number of years,

after which time they decline in unision. The comovement is much weaker in the

neoclassical model, especially during the ﬁrst ﬁve years following the onset of the

shock. Moreover, what little positive comovement does occur during this period is

mostly unforecastable. While consumption is rising over several years, hours and

output are falling, making the forecastable comovement between consumption and

the other two series negative rather than positive.

3.5 Nonlinear Dynamics

The degree of curvature embedded in the short-run aggregate supply curve plays an

important role in conditioning the putty-clay model’s response to shocks. For small

shocks such as those discussed above, the magnitude of the response to positive

and negative shocks is roughly the same. As we consider larger disturbances, the

curvature of the short-run aggregate supply curve away from steady-state becomes

important, and the model’s dynamic responses display interesting asymmetries. In

particular, the model delivers the result that a response to negative shocks is more

rapid and larger than that to positive shocks. This is consistent with the evidence on

the response to monetary shocks documented by Cover (1992) and that to oil price

shocks studied by Tatom (1988) and Mork (1989). In a business cycle context, this

18

Figure 5: Persistent Cost of Labor Shock

0.0

0.2

0.4

0.6

0.8

0 5 10 15 20 25 30

Putty-Clay Model

Output

Hours

Consumption

years

0.0

0.2

0.4

0.6

0.8

1.0

1.2

0 5 10 15 20 25 30

Neoclassical Model

Output

Hours

Consumption

years

pattern of asymmetric responses can imply that recessions are deeper and steeper

than expansions, a result consistent with the time series evidence documented by

Neftci (1984), Sichel (1993), and Potter (1995).

For the type of shocks considered here, the most likely source of large shocks in

an economy such as the U.S. come through changes in tax policy that aﬀect factor

prices.

16

An investment tax credit or a revision in personal income tax rates are

plausible sources of persistent movements in factor costs of 10% or more. To display

the model’s ability to generate asymmetries, we therefore consider the diﬀerential

16

Other potential sources of large shocks are energy prices and monetary disturbances.

19

Figure 6: Asymmetries in Response to Labor Cost Shocks

∗

0

1

2

3

4

5

0 2 4 6 8 10

Labor

years

0

1

2

3

4

5

0 2 4 6 8 10

Output

years

-2

-1

0

1

2

3

4

5

0 2 4 6 8 10

Consumption

years

0

2

4

6

8

10

12

14

16

0 2 4 6 8 10

Investment

years

10% Increase

10% Decrease

* Impulse Responses to 10% Increase in Cost of Labor Displayed with Reverse Sign

eﬀect of a 10% increase versus decrease in the labor cost shock considered above.

The results reported in Figure 6 reveal the basic source of the asymmetry. A

labor cost increase causes an immediate shutdown of machines as the economy

moves down the relatively ﬂat portion of the short-run aggregate supply curve.

This immediate shutdown produces a sharp contraction in output and hours in

both the initial and subsequent periods. Owing to the shutdown, the economy has

excess machine capacity, and investment drops sharply in response to the shock. In

contrast, a labor cost decrease has little immediate eﬀect on either output or hours as

the economy is pushed up the steep portion of the short-run aggregate supply curve.

20

Evidence of non-linearity only disappears after 6-8 years as capacity eventually

adjusts. As a result, in the putty-clay model, large contractionary shocks cause steep

immediate declines in output and hours while large expansionary shocks generate

a hump-shaped dynamic response even more pronounced than in the case of small

expansionary shocks. Of particular interest here is the fact that the asymmetries

on labor are the most pronounced, a result supported by Neftci (1984)’s non-linear

time series analysis.

4 Permanent Technology Shocks

An important unresolved issue in macroeconomics is the extent to which perma-

nent innovations in technology can explain output ﬂuctuations at the business cycle

frequency. While past research has claimed varying degrees of success, more re-

cent work has tempered enthusiasm for business cycle theories based on permanent

technology shocks. Cogley and Nason (1995) and Rotemberg and Woodford (1996)

demonstrate that the standard neoclassical model with permanent disembodied pro-

ductivity shocks is unable to match the persistence and comovement properties of

key aggregate variables. Christiano and Eichenbaum (1992) show that such models

predict excessive contemporaneous correlation between output growth and labor-

productivity growth. In this section, we extend this literature in two directions by

analyzing the eﬀects of permanent embodied, as well as disembodied, technology

shocks and allowing for putty-clay technology. Greenwood et al. (1997) argue that

the evidence supports embodied technology as the primary source of technological

change, making the analysis of such shocks of particular interest. As shown below,

the putty-clay model generates dynamic responses to permanent technology shocks

that accord well with key properties of the data.

We begin with an analysis of the persistence properties of the two models. The

ﬁrst row of table 1 shows the unconditional autocorrelation of output growth for the

two models for each type of technology shock.

17

For comparison, this statistic is es-

timated to be 0.3 in the data. An alternative measure of persistence, emphasized by

Rotemberg and Woodford (1996), is the ratio of standard deviations of forecastable

output growth to total output movements. The second and third rows of the table

report this statistic at the four- and eight-quarter horizons. For comparison, these

17

All model moments reported in this paper are computed using the linearized model.

21

Table 1: Output Persistence with Permanent Technology Shocks

Neoclassical Model Putty-clay Model

Disembodied Embodied Disembodied Embodied

cor(∆y

t

, ∆y

t−1

) 0.01 0.07 0.03 0.80

σ

∆ˆ y

t,4

/σ

∆y

t,4

0.06 0.25 0.14 0.83

σ

∆ˆ y

t,8

/σ

∆y

t,8

0.08 0.3 0.17 0.77

Notes: Shocks are permanent. y denotes the log of output. ∆ˆ y

t,j

=

E

t

(y

t+j

− y

t

), where expectations are based on date t information. All

reported moments are asymptotic means.

are estimated to be about 0.6–0.7 in the data.

Two results stand out clearly in table 1. First, the putty-clay model delivers

signiﬁcantly more persistence in output growth (by either measure and for either

type of permanent technology shock) than the neoclassical model. Second, em-

bodied technology shocks generate much more persistence in output growth than

disembodied shocks. This is especially true for the putty-clay model, which, when

driven solely by permanent embodied technology shocks, actually overpredicts the

persistence in output growth observed in U.S. post war data.

The intuition behind these results is provided by the impulse responses to perma-

nent technology shocks, plotted in Figure 7. In both the putty-clay and neoclassical

models, the long run eﬀect of a 1 − α percentage increase in technology is to raise

output, consumption and investment by 1% while leaving the long-run level of labor

unchanged. In the case of disembodied shocks (shown in the panels on the right)

total factor productivity increases immediately, causing an immediate expansion of

output. This initial increase in output represents a large fraction of the permanent

increase. As a result, for both the neoclassical and putty-clay models, nearly all

of the output dynamics are unforecastable, and output growth displays very little

persistence in response to disembodied shocks to technology.

If technology shocks are embodied in capital (shown in the panels on the left)

total factor productivity does not increase until the economy invests in new capital

goods. In the neoclassical model, a positive shock to embodied technology still

causes a large immediate expansion in output as hours surge in response to the high

22

Figure 7: Permanent Productivity Shocks

0.0

0.2

0.4

0.6

0.8

1.0

1.2

0 5 10 15 20

Output

years

0.0

0.2

0.4

0.6

0.8

1.0

1.2

0 5 10 15 20

Output

Putty-Clay

Neoclassical

years

-0.5

0.0

0.5

1.0

1.5

0 5 10 15 20

Consumption

years

0.0

0.2

0.4

0.6

0.8

1.0

1.2

0 5 10 15 20

Consumption

years

0.0

0.2

0.4

0.6

0.8

1.0

0 5 10 15 20

Labor

years

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0 5 10 15 20

Labor

years

Embodied Technology Shock Disembodied Technology Shock

rate of return to investment. Because of the rapid expansion in production, the

initial output response represents a large fraction of the permanent response and

output movements are mostly unpredictable. In the putty-clay model, a positive

shock to embodied technology causes only a small initial expansion despite the

increased desire for new investment, owing to the high costs of expanding production

in the short-run. Both output and hours expand slowly as new capital is brought

on-line, with labor reaching its peak response a number of years after the shock

occurs. As a result, most of the output dynamics are predictable and output growth

displays a high degree of persistence in response to embodied shocks to technology.

23

Table 2: Forecastable Comovement Between Output and Hours

Neoclassical Model Putty-clay Model

Disembodied Embodied Disembodied Embodied

cor(∆

ˆ

h

t,4

, ∆ˆ y

t,4

) -1.00 -1.00 0.44 0.44

cor(∆

ˆ

h

t,8

, ∆ˆ y

t,8

) -1.00 -1.00 0.28 0.28

Notes: h denotes the log of hours. See also Table 1.

In addition to the limited degree of internal propagation, Rotemberg and Wood-

ford (1996) criticize the high negative correlations between predictable movements in

output and hours implied by the standard neoclassical model in response to random

walk technology shocks. Table 2 formalizes this point by reporting the correlation

between forecastable growth of output and hours four and eight quarters ahead.

For comparison, these correlations are estimated to be about 0.86 in the data. For

the neoclassical model, the negative correlation follows from the fact that the peak

response in hours occurs at the onset of the shock while output continues to grow as

capital accumulation proceeds. Thus, while hours are falling in a predictable fash-

ion, output is rising in a predictable fashion. The putty-clay model’s slow expansion

of output and hours reverses this correlation and provides a closer match with the

data on this dimension.

Finally, we consider the models’ predictions regarding the contemporaneous cor-

relation between output and productivity growth. Table 3 reports this correlation

for the two models for each of the two sources of permanent productivity shocks.

For comparison, this correlation is estimated to be 0.76 in the data. If hours were

held constant, both models would predict a perfectly positive correlation between

growth in output and productivity. With disembodied shocks, this correlation is

nearly unity as the eﬀect of the movements in hours on productivity are dwarfed by

the eﬀects of the shock itself.

In the case of embodied technology shocks, the models’ predictions diﬀer greatly.

The neoclassical model predicts a highly negative correlation between growth in

output and productivity. This negative correlation results from the immediate ex-

pansion of hours which produces a large decline in productivity at the same time as

the largest increase in output. The putty-clay model, on the other hand, predicts

24

Table 3: Output and Productivity Growth Comovement

Neoclassical Model Putty-clay Model

Disembodied Embodied Disembodied Embodied

cor(∆y

t

, ∆p

t

)) 0.99 -0.71 1.00 0.50

Notes: p denotes the log of output per hour. See also Table 1.

a positive correlation between output and productivity growth. This diﬀerence lies

in the muted expansion of hours, which does less to oﬀset the positive comovement

in productivity and output directly resulting from the shock. The putty-clay model

thus provides an explanation for why the correlation between growth in output and

productivity may be positive but less than unity, even in the absence of shocks to

demand.

Although embodied shocks help explain a number of empirical regularities, some

results are not consistent with the business cycle. In particular, both the neoclas-

sical and putty-clay models create excess volatility of consumption and investment

relative to the data (as seen in the set of moments reported in the appendix). This

excess volatility occurs because factor cost movements create investment patterns

that overwhelm the usual desire to smooth consumption.

5 Estimation

The results in the previous section highlight the putty-clay model’s ability to explain

key business cycle facts such as persistence in output growth and positive predictable

comovement between output and hours. In this section we provide a more formal

evaluation of the empirical relevance of a putty-clay production process in matching

key moments of U.S. aggregate data.

To perform this evaluation, we construct a two-sector model that nests both the

putty-clay model and the neoclassical model within the same econometric frame-

work. Letting θ

t

denote the level of technology embodied in capital, we assume that

sector 1 output is derived from the putty-clay production process describe above,

while sector 2 output is derived from the Solow vintage-capital model described in

the appendix. Letting A

t

denote the level of disembodied technology, we assume

25

that ﬁnal-goods output is a Cobb-Douglas function of sectoral output:

Y

t

= A

t

Y

λ

1t

Y

1−λ

2t

We then estimate λ, the share of output obtained from the putty-clay sector. If

our estimate of λ is close to unity, the data eﬀectively put a large weight on putty-

clay production in order to match the vector of moments that we consider. If our

estimate of λ is close to zero, the data suggest little if any role for putty-clay in

explaining the moments we choose to match.

To address recent criticisms regarding standard RBC-style moment-matching ex-

ercises, our methodology relies on both unconditional moments traditionally empha-

sized in the RBC literature and conditional moments emphasized by Rotemberg and

Woodford (1996).

18

The unconditional moments include the standard deviations of

(the growth rates of) investment and hours relative to the standard deviation of

output, the correlations of investment and hours with output, and the ﬁrst-order

autocorrelations of these variables. The conditional moments include correlations

and regression coeﬃcients among predictable changes in output, investment and

hours over a four-quarter horizon.

19

These moments also include the ratio of the

standard deviation of the predictable change in output relative to the standard

deviation of the total change in output at this horizon.

To compute moments constructed from predictable components we specify a

VAR process for (y

t

, h

t

, i

t

), the logs of output, hours, and investment in the data.

20

As shown in the appendix, the statistical properties and hence all relevant moments

of this VAR are summarized by an unknown parameter vector ξ. We estimate ξ using

standard time-series techniques and then use the resulting parameter estimate to

compute a set of moments g(

ˆ

ξ), along with the variance of these moments V

g

.

Our estimation strategy is to choose λ, the share of output accounted for by the

18

Christiano and Eichenbaum (1992) provide a GMM procedure for estimating and evaluating

business-cycle models based on unconditional moments. A contribution of this paper is to provide

a GMM procedure that allows for both types of moments within a uniﬁed econometric framework.

19

Results using a combination of moments computed from predictable changes at the 4,8 and 16

quarter horizon do not alter our conclusions.

20

Our investment series is business ﬁxed investment (non-residential equipment and structures).

In the model, investment is a linear combination of output and consumption so that consumption

and investment contain the same information when combined with output. An alternative approach

to the data is to deﬁne investment as a linear combination of output and non-durables consump-

tion. Although less desirable for a model explicitly designed to capture short-run capital/labor

complementarities we have considered this approach, as well as matching moments computed from

total consumption rather than investment. Neither of these alternatives alter our empirical results

in any substantial way.

26

putty-clay sector, along with other relevant parameters, to minimize the distance

between model moments and data moments. For a given vector ψ of unknown model

parameters, we use our model solution to compute g

M

(ψ), the model’s analog of g(ξ).

By minimizing

L(ψ) = (g

M

(ψ) −g(

ˆ

ξ))

V

−1

g

(g

M

(ψ) −g(

ˆ

ξ))

with respect to ψ we obtain the minimum distance estimator

ˆ

ψ. For a time-series

sample of size T, T ∗ L(

ˆ

ψ) provides a χ

2

test for equality between g

M

(

ˆ

ψ) and g(

ˆ

ξ).

For our moment matching exercise, we consider two independant sources of ﬂuc-

tuations: disembodied technological change and embodied technological change. We

assume that shocks follow an AR1 process and then freely estimate [ρ

A

, ρ

θ

], the auto-

correlations of the shock processes, and

σ

θ

σ

A

+σ

θ

, the relative importance of embodied

shocks. To generalize our results beyond technology shocks, we also consider a model

that includes labor cost shocks. Under this speciﬁcation, we also estimate the auto-

correlation of labor cost shocks, and the percentage of ﬂuctuations attributable to

labor cost shocks.

Estimation results based on unconditional moments reported in table 4 place a

large weight on the putty-clay production technology – on the order of 50% for the

model that does not include labor cost shocks.

21

The estimate of

σ

θ

σ

A

+σ

θ

is about 0.2,

suggesting a substantial role for embodied technology shocks in explaining aggregate

dynamics.

22

For comparison purposes, table 4 also reports h

M

(ψ) and T ∗ L(ψ) for

the standard RBC model with disembodied shocks and ρ

A

= 0.95. Relative to this

baseline, allowing for embodied shocks and a non-zero weight on putty-clay provides

a substantial gain in terms of ﬁt, reducing T ∗L(ψ) by 50%.

23

. In this speciﬁcation,

the estimated values of ρ

A

and ρ

θ

reach their upper bound of unity, emphasizing

the importance of persistent shocks when matching unconditional moments.

Introducing labor cost shocks provides further gains in ﬁt and places even greater

emphasis on putty-clay technology. The gain in ﬁt comes from a relatively large

fraction of ﬂuctuations being accounted for by labor cost shocks. Our estimation

results also set ρ

L

, the autocorrelation of labor cost shocks, at an imposed upper

21

The putty-clay share is estimated precisely with a standard error of about 0.02.

22

As an alternative to estimating

σ

θ

σ

A

+σ

θ

, we considered ﬁxing this ratio at 0.6, Greenwood et

al. (1997)’s estimate of the share of post-war technological change embodied in capital. Assuming

random walk shocks and setting σL = 0, we estimate a putty-clay share of 0.69, indicating that our

estimate of the putty-clay share is robust to changes in the mix of technology shocks.

23

Nonetheless, we still reject a test of equality between model and data moments. This may

partly reﬂect the poor small-sample properties of such tests (Burnside and Eichenbaum 1996).

27

Table 4: Unconditional Moments: Estimation of Two-Sector Model

Neoclassical Two-Sector Data

Benchmark Model Est. S. E.

Model Parameters:

Putty-Clay Share 0 0.47 0.67

σ

θ

σ

θ

+σ

A

1

0 0.23 0.21

σ

L

σ

θ

+σ

A

+σ

L

2

0 0 0.55

ρ

θ

1.00 1.00

ρ

A

0.95 1.00 1.00

ρ

L

0.99

3

Moments:

σ

∆h

/σ

∆y

0.57 0.39 0.66 0.65 0.04

σ

∆i

/σ

∆y

2.85 2.49 2.39 1.80 0.11

cor(∆h

t

, ∆y

t

) 0.99 0.69 0.61 0.74 0.04

cor(∆i

t

, ∆y

t

) 1.00 0.87 0.89 0.61 0.05

cor(∆y

t

, ∆y

t−1

) -0.02 0.08 0.12 0.32 0.08

cor(∆h

t

, ∆h

t−1

) -0.04 0.21 0.26 0.61 0.06

cor(∆i

t

, ∆i

t−1

) -0.03 0.07 0.12 0.50 0.07

Minimized Objective: 708 361 246

1.

σ

θ

σ

θ

+σA

measures the share of technology shocks embodied in capital.

2.

σL

σ

θ

+σA+σL

measures the relative magnitude of labor market shocks.

3. Estimate constrained by upper bound of 0.99.

bound of 0.99. Thus, even with the introduction of labor cost shocks, our moment

matching exercise still places a strong emphasis on highly persistent shocks. Given

the importance of all three shocks in the estimation procedure, it is interesting

to ask what fraction of output variance is accounted for by each shock. Variance

decompositions using estimated parameter values imply that disembodied, embodied

and labor cost shocks account for 76%, 4% and 20% of output ﬂuctuations at the

one-year horizon and 63%, 11% and 26% at the ﬁve-year horizon.

Estimation results based on the full set of moments reported in Table 5 also

imply a large putty-clay share – on the order of two-thirds, regardless of the shock

processes. Introducing putty-clay technology provides substantial gain in ﬁt, which

is further improved through the introduction of labor cost shocks. When considering

the full set of moments, the estimate of

σ

θ

σ

A

+σ

θ

drops from about 0.2 to zero, and

the persistence of disembodied shocks falls to 0.94. The drop in

σ

θ

σ

A

+σ

θ

is oﬀset

28

Table 5: All Moments: Estimation of Two-Sector Model

Neoclassical Two-Sector Data

Benchmark Model Est. S. E.

Model Parameters:

Putty-Clay Share 0 0.68 0.64

σ

θ

σ

θ

+σ

A

0 0.01 0.00

σ

L

σ

θ

+σ

A

+σ

L

0 0 0.64

ρ

θ

0.98

ρ

A

0.95 0.95 0.94

ρ

L

0.99

1

Moments:

σ

∆h

/σ

∆y

0.57 0.30 0.67 0.65 0.04

σ

∆i

/σ

∆y

2.85 2.60 2.67 1.80 0.11

cor(∆h

t

, ∆y

t

) 0.99 0.96 0.75 0.74 0.04

cor(∆i

t

, ∆y

t

) 1.00 0.99 0.99 0.61 0.05

cor(∆y

t

, ∆y

t−1

) -0.02 0.06 0.09 0.32 0.08

cor(∆h

t

, ∆h

t−1

) -0.04 0.24 0.25 0.61 0.06

cor(∆i

t

, ∆i

t−1

) -0.03 0.04 0.08 0.50 0.07

cor(∆

ˆ

h

t,4

, ∆ˆ y

t,4

) 0.89 0.90 0.82 0.89 0.04

cor(∆

ˆ

i

t,4

, ∆ˆ y

t,4

) 0.94 0.84 0.80 0.86 0.05

α

(∆

ˆ

h

t,4

,∆ˆ y

t,4

)

0.80 0.43 0.53 0.64 0.10

α

(∆

ˆ

i

t,4

,∆ˆ y

t,4

)

3.60 2.99 2.80 1.83 0.27

σ

∆ˆ y

t,4

/σ

∆y

t,4

0.27 0.25 0.26 0.62 0.07

Minimized Objective: 1148 786 444

1. Estimate constrained by upper bound of 0.99.

by an increase in the percentage of ﬂuctuations obtained from labor cost shocks.

Computing variance decompositions using estimates in Table 5, we ﬁnd that labor

cost shocks account for 15% of output ﬂuctuations at the one-year horizon, and 47%

at the ﬁve-year horizon. These results imply that disembodied shocks to technology

do well at explaining output movements at high frequencies, while persistent shocks

to factor costs do better at lower frequencies.

24

24

As robustness checks to our estimation results, we have considered a number of issues, including

alternative parameterizations of the utility function and the presence of convex adjustment costs for

investment. For estimation based on unconditional moments, lowering the intertemporal elasticity

of substitution or adding adjustment costs increases both the putty-clay share and

σ

θ

σ

θ

+σ

A

. By

raising γ or introducing adjustment costs, we reduce the volatility of consumption and investment

29

6 Conclusion

By combining investment irreversibilities, capacity constraints, and variable capacity

utilization, the putty-clay model developed in this paper provides a rich framework

for analyzing a number of issues regarding investment, labor, capacity utilization,

and productivity. In this paper we highlight some implications for employment, out-

put, and investment at business cycle and medium-run frequencies. Compared to

standard neoclassical models, the putty-clay model displays a substantial degree of

persistence and propagation for both output and hours in response to shocks to fac-

tor costs and technology. And, unlike standard neoclassical models, the putty-clay

model generates forecastable comovements between labor, output, and consumption

consistent with the data. Finally, owing to the existence of a nonlinear aggregate

supply curve, the putty-clay model generates interesting asymmetries with reces-

sions steeper and deeper than expansions.

Beyond its descriptive appeal, the putty-clay production process is also found

to be empirically relevant for explaining business-cycle and medium-run dynamics.

Estimates obtained from a two-sector model that minimize the distance between

moments generated by the model and those obtained from the data place a sizable

weight on putty-clay production – on the order of one-half to three-fourths. This

ﬁnding is robust to the speciﬁcation of the shock processes and the choice of mo-

ments used in the estimation. In addition to supporting a major role for putty-clay

technology, our results suggest that factor price shocks may be key to explaining

ﬂuctuations, especially at the medium-run frequencies of two to eight years.

This paper focuses on the eﬀects of factor-cost shocks and technological change

for business-cycle dynamics. The putty-clay model developed here has broader ap-

plications for ﬁscal, monetary and trade policy, and the study of transitional dynam-

ics for growing economies. In particular, this paper highlights the notion that the

short-run eﬀects of policy may be substantially diﬀerent from their medium-term

consequences, owing to the linkage between the capital accumulation process and

labor market dynamics.

in response to movements in factor costs. When considering the full set of moments we ﬁnd little

sensitivity to such speciﬁcations.

30

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34

Appendix

In this appendix we describe the derivation of the neoclassical vintage model, the

solution methods for the dynamic model, details of the econometric procedure along

with a complete description of the two-sector model used in section 5. At the end of

this appendix we also provide complete tables for the moments of the neoclassical

and putty-clay models with permanent technology shocks.

Derivation of the Neoclassical Vintage Model:

For the purpose of comparison, we construct a neoclassical model of vintage capital,

initially introduced by Solow (1962). In this model, the restriction that ex post

capital-labor ratios are ﬁxed is removed. The two models are otherwise identical.

Let I

t−j

denote aggregate investment in period t−j, and deﬁne the following capital

aggregator

K

t

=

M

¸

j=1

θ

1/α

t−j

(1 −δ

j

)I

t−j

Period t labor and output of machine i created in period t −j satisﬁes:

L

t,t−j

(i) = ((1 −α)θ

it−j

/W

t

)

1/α

(1 −δ

j

)I

t−j

and

Y

t,t−j

(i) = θ

i,t−j

1/α

((1 −α)/W

t

)

(1−α)/α

(1 −δ

j

)I

t−j

where (1 −δ

j

)I

t−j

represents the capital remaining at time t that was put in place

at time t − j. Integrating over machines with respect to the distribution of θ

i,t−j

,

and using the result that

E(θ

i,t−j

1/α

) = θ

1/α

t−j

exp(

σ

2

2α

1 −α

α

)

provides the relationship between total vintage t −j output and labor inputs:

(1 −α)Y

t,t−j

= W

t

L

t,t−j

where

Y

t,t−j

= A

1−α

θ

1/α

t−j

(1 −δ

j

)I

t−j

α

L

1−α

t,t−j

and A = exp(

σ

2

2α

). Summing across vintages we obtain

Y

t

= ((1 −α)A/W

t

)

(1−α)/α

K

t

35

L

t

= ((1 −α)A/W

t

)

1/α

K

t

.

Combining these two expressions gives the aggregate production function

Y

t

= A

1−α

K

α

t

L

1−α

t

where L

t

is aggregate labor input and A = exp(

σ

2

2α

) is a scale correction that results

from aggregating across machines at the idiosyncratic level.

If we assume that δ

j

= 1 − (1 − δ)

j−1

and M = ∞, we obtain the following

capital accumulation equation

K

t

= (1 −δ)K

t−1

+θ

1/α

t−1

I

t−1

Thus, shocks to embodied technological change are identical to shocks to the true

economic cost of new capital goods.

Solution Methods:

The model consists of 2M + N state variables, including average machine eﬃcien-

cies, X

t−j

, j = 1, . . . , M, and the quantity of new machines per vintage, Q

t−j

, j =

1, . . . , M, for each of the M vintages in existence, and N shocks. Owing to the

log-normal distribution of X

it

, these state variables completely summarize the ex-

isting distribution of machines depicted in Figure 1. By choosing M suﬃciently

large we provide an arbitrarily good approximation to the case M = ∞. For values

of M large enough to analyze business-cycle frequency properties of the model, the

state-space is too large for the type of nonlinear state-space methods discussed in

Judd (1998). Instead, depending on the purpose, we apply one of two methods that

yield approximate solutions at relatively low computational cost.

The ﬁrst method uses a log-linearization around the deterministic steady state of

the equations describing the equilibrium. The resulting linear model, which includes

M leads and lags of ln(X) and ln(Q), is then solved using the AIM implementation

of the Blanchard-Kahn method due to Anderson and Moore (1985). This algorithm

yields accurate solutions for values at relatively low computational cost for M up to

40, which is suﬃciently large for an annual version of the model. For the quarterly

version of the model, M = 40 implies capital goods completely depreciate within 10

years, which seems to be an unrealistically short lifespan. Thus, following Gilchrist

and Williams (1998a), we use polynomial distributed leads and lags to approximate

the M = ∞ leads and lags of variables. For example, for some variable u and

36

coeﬃcient sequence {a

j

}

∞

1

, we approximate the sum

¸

∞

j=1

a

j

u

t−j

by the polynomial

distributed lag (or lead)

u

t−1

B(L)

, where B(L) = b

0

−b

1

L−b

2

L

2

−. . .−b

p

L

p

and p is ﬁnite.

For the putty-clay model we use p = 1 and chose values corresponding to b

0

and

b

1

that minimize the weighted squared deviations between the PDL representation

and the original lag or lead structure; this approximations yields virtually no loss

in accuracy for model simulations. This adds 8 equations to our model and reduces

the maximum lead and lag from M to 1, thus drastically reducing the size of the

companion form of the model. The solution time for this approximate model is

trivial.

The log-linearized model, approximated in the manner described above, is used

for the simulations reported in the paper except for those illustrating the asym-

metrical response to large shocks shown in ﬁgure 6, which requires a method that

preserves the nonlinearities of the model. For those simulations an extended path

algorithm based on Fair and Taylor (1983) is used for a model with M = 160. This

method requires far more memory and CPU time than the linearization method

described above. For small shocks, the two methods yield nearly identical answers.

Both of these methods compute “certainty-equivalent” solutions; that is, expec-

tations are computed assuming all future shocks equal their mean values of zero. To

address this issue, we used projection methods to solve a version of the model with

small M. This approach, described in Judd (1992), uses polynomial approxima-

tions to the decision rules and multi-point quadrature to approximate expectation

integrals and therefore does not impose certainty equivalence on the solutions. We

found that the solutions were very close to those generated using the extended

path algorithm, implying that the certainty equivalent solution provides a good ap-

proximation even in the presence of substantial non-linearities and reasonably large

aggregate shocks.

Econometric Methodology for Moment Matching Exercise

In this section of the paper we present our moment matching methodology. We start

by specifying a stochastic process for the log of output, hours and investment in the

data which depends on an unknown parameter vector θ which is to be estimated.

Our approach follows Rotemberg and Woodford’s method of specifying a tightly

parameterized low-order VAR system to characterize the data. Our data consists

of private non-farm output, total private hours and non-residential business ﬁxed

37

investment (equipment and structures) for the period 1960-1997. Relative to GDP,

the output and hours series exclude government and farm output as well as the

imputed output obtained from owner-occupied housing. The output and hours

series are thus deﬁned in a mutually consistent manner. With the exception of

agricultural investment in structures and machinery, the investment series is also

consistent with the output and hours series. Both the output and the investment

series are deﬂated using 1997 chain weighted-deﬂators.

After ﬁrst removing a linear time trend from the hours series, we assume that

the ﬁrst diﬀerence of the log of output, the log of the investment/output ratio and

the log of hours, [∆y

t

, i

t

−y

t

, h

t

] can be represented using a two-lag stationary VAR

representation. Deﬁning

u

t

= [∆y

t

, i

t

−y

t

, h

t

, ∆y

t−1

, i

t−1

−y

t−1

, h

t−1

], E(u

t

u

t

) = Σ

u

e

t

= [e

y

t

, e

i

t

, e

h

t

], E(e

t

e

t

) = Σ

e

, E(e

t

e

t+s

) = 0 for s = 0

we express the stochastic process for u

t

in companion form as:

u

t

= Au

t−1

+v

t

, A =

¸

Π

I 0

¸

, v

t

=

¸

e

t

0

¸

, E(v

t

v

t

) = Σ

v

where Π is a matrix of VAR coeﬃcients. Deﬁning D

n

as the duplication matrix such

that D

n

vech(Σ

e

) = vec(Σ

e

), the parameter vector ξ and its associated variance is

then:

ξ =

¸

vec(Π)

vech(Σ

e

)

¸

, V

ξ

=

¸

Σ

e

⊗Σ

−1

u

0

0 Σ

22

¸

where Σ

22

= 2D

+

n

(Σ

e

⊗ Σ

e

)(D

+

n

)

for D

+

n

= (D

n

D

n

)

−1

D

n

. (Hamilton (1994) pp

301-302 provides details.)

Given this speciﬁcation for the stochastic process for output, hours and invest-

ment, we are interested in computing second moments of both the kth diﬀerences

of these variables as well as second moments of the forecastable components of the

kth diﬀerences, where the forecast is made conditional on time t − k information.

To obtain expressions for these second moments as functions of the underlying VAR

parameters, we ﬁrst express the kth diﬀerences in y

t+k

, i

t+k

and h

t+k

as functions

of data known at time t and shocks that occur between t and t + k. For x = y, i, h

we have:

∆x

t,k

≡ x

t+k

−x

t

= b

x

k

u

t

+

k

¸

j=1

d

x

j

v

t+j

38

where

b

y

k

= e

1

k

¸

i=1

A

i

, b

i

k

= b

y

k

+e

2

(A

k

−I), b

h

k

= e

3

(A

k

−I)

d

y

j

= e

1

j

¸

s=1

A

s−1

, d

i

j

= d

y

j

+e

2

A

j−1

, d

h

j

= e

3

A

j−1

.

Taking expectations as of time t, the predictable components of the kth diﬀerence

of x is:

∆ˆ x

t,k

≡ E

t

{x

t+k

−x

t

} = b

x

k

u

t

Computing second moments, we obtain an expressions for the variance of ∆x

t,k

σ

2

x,k

≡ E(∆x

t,k

)

2

= (b

x

k

)Σ

u

(b

x

k

)

+

k

¸

j=1

(d

x

j

)Σ

v

(d

x

j

)

**The covariance between ∆x
**

t,k

, and ∆y

t,k

is obtained from

σ

xy,k

≡ E(∆x

t,k

∆y

t,k

) = (b

x

k

)Σ

u

(b

y

k

)

+

k

¸

j=1

(d

x

j

)Σ

v

(d

y

j

)

.

Similarly, the variance of the predictable component of the kth diﬀerence in x is

simply

σ

2

ˆ x,k

≡ E(∆ˆ x

t,k

)

2

= (b

x

k

)Σ

u

(b

x

k

)

**while the covariance between the predictable components of the kth diﬀerences of x
**

with y is obtained from:

σ

ˆ xy,k

≡ E(∆ˆ x

t,k

∆ˆ y

t,k

) = (b

x

k

)Σ

u

(b

y

k

)

**To compute autocorrelations among kth diﬀerences, note that E(∆x
**

t+k,k

∆x

t,k

) =

E(∆x

t,2k

∆x

t,k

) − E(∆x

t,k

)

2

. From the expressions obtained above we then have

E(∆x

t,2k

∆x

t,k

) −E(∆x

t,k

)

2

= b

x

2k

Σ

u

(b

x

k

)

−b

x

k

Σ

u

(b

x

k

)

implying that

ρ

x,k

≡

E(∆x

t+k,k

, ∆x

t,k

)

E(∆x

t,k

)

2

=

(b

x

2k

−b

x

k

)Σ

u

(b

x

k

)

(b

x

k

)Σ

u

(b

x

k

)

**Using these expressions, we deﬁne two sets of moments. The ﬁrst set of moments
**

are the unconditional standard deviations of ∆i

t,k

, ∆h

t,k

relative to the uncondi-

tional standard deviation of ∆y

t,k

, the unconditional correlations of ∆i

t,k

, ∆h

t,k

with ∆y

t,k

, and the autocorrelations of ∆y

t,k

, ∆i

t,k

and ∆h

t,k

:

h

1,k

=

¸

σ

i,k

σ

y,k

,

σ

h,k

σ

y,k

,

σ

iy,k

(σ

i,k

σ

y,k

)

,

σ

hy,k

(σ

h,k

σ

y,k

)

, ρ

y,k

, ρ

i,k

, ρ

h,k

¸

.

39

For k = 1 these moments are the unconditional moments considered in section 6.

The second set of moments computes regression coeﬃcients and correlations

between the predictable components of ∆i

t,k

, ∆h

t,k

and the predictable component

of ∆y

t,k

. According to Rotemberg and Woodford, these measures of the underlying

dynamic response of the system when away from steady state. Intuitively, these

statistics capture the strength and magnitude of the expected comovements among

output, investment and hours. By varying k, we vary the horizon over which the

comovements between forecastable components are computed. The second set of

moments also includes the ratio of the variance of the predictable component of

∆y

t,k

relative to the total variance of ∆y

t,k

. Again, Rotemberg and Woodford view

this statistic as providing a good indicator of the degree to which the model contains

a propagation mechanism. Thus the second set of moments may be written as:

g

2,k

=

¸

σ

ˆ

iy,k

σ

2

ˆ y,k

,

σ

ˆ

hy,k

σ

2

ˆ y,k

,

σ

ˆ

iy,k

σ

ˆı,k

σ

ˆ y,k

,

σ

ˆ

hy,k

σ

ˆ

h,k

σ

ˆ y,k

,

σ

ˆ y,k

σ

y,k

¸

.

where the ﬁrst two elements are regression coeﬃcients, the second two elements

are correlations, and the ﬁnal element is the variance ratio. Recognizing that both

g

1,1

and g

2,k

are functions of A, Σ

u

, Σ

v

and hence ultimately functions of the VAR

parameter vector ξ, we obtain our moment vector of interest: g(ξ) = [g

1,1

g

2,k

]

. To

obtain an estimate of the variance of this moment vector, we use a Taylor series

expansion of g (the delta method) to obtain V

g

=

∂g

∂ξ

V

ξ

∂g

∂ξ

.

We estimate the model parameters ψ = [a, ρ

A

, ρ

θ

, ρ

L

,

σ

θ

σ

θ

+σ

A

,

σ

L

σ

θ

+σ

A

+σ

L

] by min-

imizing the distance between g(ξ) and g

M

(ψ) where g

M

is the model’s analog of

g(ξ). To obtain g

M

as a function of ψ we rely on the fact that our model solution

is linear and may be expressed in the ﬁrst order companion form:

X

t

= AX

t−1

+BU

t

where E(U

t

U

t

) = I and X

t

is a vector of model variables with y

t

= e

y

X

t

, c

t

= e

y

X

t

and h

t

= e

h

X

t

. The moment vector g

M

may then be computed as a function of

A, B. Because the matrices A, B are (nonlinear) functions of the underlying model

parameters ψ, the moment vector g

M

is also a function of ψ. Standard errors for ψ

may then be obtained from V

ψ

= {

∂g

M

∂ψ

V

−1

g

∂g

M

∂ψ

}

−1

.

Two Sector Model:

In this section we provide a full description of the system of equations that char-

acterize the equilibrium of the two-sector model. We set the ﬁnal-goods price as

40

the numeraire and deﬁne P

1,t

and P

2,t

as the relative output prices for each sector.

Disembodied technology, A

t

, aﬀects both sectors equally.

25

We deﬁne η

t

as the labor

market shock.

Sectoral Production:

Y

1,t

=

M

¸

j=1

1 −Φ(z

t−j

t

−σ)

(1 −δ

j

)Q

t−j

X

t−j

L

1,t

=

M

¸

j=1

1 −Φ(z

t−j

t

)

(1 −δ

j

)Q

t−j

Y

2,t

= K

α

t

L

1−α

2,t

K

t

= (1 −δ)K

t−1

+θ

1/α

t−1

I

t−1

.

Optimality conditions for sectoral labor and capital accumulation:

k

t

= αE

t

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)

1 −Φ(z

t

t+j

−σ)

P

1,t+j

X

t

¸

k

t

= E

t

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)

1 −Φ(z

t

t+j

−σ)

P

1,t+j

X

t

−

M

¸

j=1

˜

R

t,t+j

(1 −δ

j

)

1 −Φ(z

t

t+j

)

W

t+j

¸

θ

−1/α

t

= E

t

R

t,t+1

αP

2,t+1

Y

2,t+1

K

t+1

+ (1 −δ)θ

−1/α

t+1

(1 −α)P

2,t

Y

2,t

L

2,t

= W

t

φ(z

t−j

t

−σ)P

1,t

X

t−j

φ(z

t−j

t

)

= W

t

, j = 1, ...M.

This last expression equates marginal products across all vintages. It could have

alternatively been written as z

t−j

t

≡

1

σ

log W

t

−log P

1,t

X

t−j

+

1

2

σ

2

.

Household ﬁrst order conditions:

U

c,t

=

β

1 +n

E

t

R

t,t+1

U

c,t+1

25

Note that the eﬀect of the level of disembodied technology on the ﬁrst-order conditions of ﬁrms

is captured by the output price terms.

41

U

c,t

η

t

W

t

+U

L,t

= 0.

Aggregate output and resource constraints:

Y

t

= A

t

Y

λ

1,t

Y

1−λ

2,t

C

t

= Y

t

−k

t

Q

t

−I

t

L

t

= L

1,t

+L

2,t

.

Shocks:

ln(A

t

) = ρ

A

ln(A

t−1

) +e

A,t

, with E(e

2

A,t

) = σ

2

A

ln(θ

t

) = ρ

θ

ln(θ

t−1

) +e

θ,t

, with E(e

2

θ,t

) = σ

2

θ

ln(η

t

) = ρ

L

ln(η

t−1

) +e

η,t

, with E(e

2

η,t

) = σ

2

L

Permanent Technology Shocks:

Tables 6 and 7 report the unconditional and forecastable moments, respectively, re-

sulting from permanent technology shocks for the two models as well as the statistics

estimated in the data.

42

Table 6: Unconditional Moments – Permanent Technology Shocks

Neoclassical Model Putty-Clay Model Data

Disemb. Embod. Disemb. Embod. Est. S. E.

σ

∆c

/σ

∆y

0.55 1.13 0.70 2.87 0.36 0.02

σ

∆h

/σ

∆y

0.36 1.57 0.09 0.91 0.66 0.04

σ

∆i

/σ

∆y

2.15 6.03 1.76 8.14 1.82 0.11

σ

∆p

/σ

∆y

0.65 0.69 0.91 0.77 0.68 0.04

cor(∆c

t

, ∆y

t

) 0.99 -0.83 0.99 -0.12 0.52 0.06

cor(∆h

t

, ∆y

t

) 0.98 0.95 0.96 0.68 0.74 0.04

cor(∆i

t

, ∆y

t

) 0.99 0.97 0.99 0.53 0.60 0.05

cor(∆p

t

, ∆y

t

) 0.99 -0.71 1.00 0.50 0.76 0.03

cor(∆y

t

, ∆y

t−1

) 0.01 0.07 0.04 0.80 0.31 0.08

cor(∆c

t

, ∆c

t−1

) 0.10 0.05 0.10 0.06 0.34 0.08

cor(∆h

t

, ∆h

t−1

) -0.03 -0.03 0.20 0.20 0.60 0.06

cor(∆i

t

, ∆i

t−1

) -0.02 -0.02 -0.01 -0.02 0.50 0.07

cor(∆p

t

, ∆p

t−1

) 0.06 0.18 0.03 0.73 0.60 0.06

Table 7: Forecastable Moments – Permanent Technology Shocks

Neoclassical Model Putty-Clay Model Data

Disemb. Embod. Disemb. Embod. Est. S. E.

cor(∆ˆ c

t,4

, ∆ˆ y

t,4

) 1.00 1.00 1.00 1.00 0.95 0.07

cor(∆

ˆ

h

t,4

, ∆ˆ y

t,4

) -1.00 -1.00 0.44 0.44 0.86 0.06

cor(∆

ˆ

i

t,4

, ∆ˆ y

t,4

) -1.00 -1.00 -0.98 -0.98 0.76 0.07

cor(∆ˆ p

t,4

, ∆ˆ y

t,4

) 1.00 1.00 0.95 0.95 0.76 0.10

α

(∆ˆ c

t,4

,∆ˆ y

t,4

)

3.18 3.18 1.61 1.61 0.22 0.07

α

(∆

ˆ

h

t,4

,∆ˆ y

t,4

)

-1.68 -1.68 0.14 0.14 0.59 0.09

α

(∆

ˆ

i

t,4

,∆ˆ y

t,4

)

-4.44 -4.44 -0.49 -0.49 1.70 0.24

α

(∆ˆ p

t,4

,∆ˆ y

t,4

)

2.68 2.68 0.86 0.86 0.41 0.09

σ

∆ˆ y

t,4

/σ

∆y

t,4

0.06 0.25 0.14 0.83 0.64 0.06

σ

∆ˆ y

t,8

/σ

∆y

t,8

0.08 0.30 0.17 0.77 0.71 0.07

σ

∆ˆ y

t,16

/σ

∆y

t,16

0.09 0.31 0.18 0.67 0.65 0.06

43

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